Overconfidence Games: Why to Be Wary of Advisers Who Are '100% Sure'

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You may find overconfidence in others or yourself to be a trait that's harmless, perhaps charming, or even annoying. You likely find it more compelling in an adviser than prudent caution. But that attraction to certainty can cost you a lot of money, and possibly more than that.

Consider a report on a recent study from researchers at University of California, Berkeley, and Georgetown University, titled "Cheap Talk and Credibility: The Consequences of Confidence and Accuracy on Advisor Credibility and Persuasiveness."

The authors examined confidence and accuracy among advisers and found that those who were confident but inaccurate took a larger credibility hit from clients than those who had originally hedged. That's as it should be: The proof, after all, should be in the pudding, right?

But part two of the study's findings is more troubling. Researchers also found that "when feedback on adviser accuracy is unavailable or costly, confident advisers hold sway regardless of accuracy."

And, according to the report, "People also made less effort to determine the accuracy of confident advisers; interest in buying adviser performance data decreased as the adviser's confidence went up." (Or, "I don't need to taste the pudding. I'll take this person's word for it that it's great.")

In other words, advisers are often able to get away with being overconfident -- and wrong. As customers, it means we need to be more wary -- not less -- of advisers who present their suggestions with a great deal of gusto.

Think back to the 1998 implosion of Long-Term Capital Management, a hedge fund run by several Nobel Prize winners. It was probably easy for its investors to have confidence in the brilliant management team, but many billions of dollars were lost. Likewise, it's often easy for folks such as the managers themselves to have great confidence in themselves, due to their experience and expertise.

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More recently, in 2006, a study found that 74 percent of fund managers believed that their performance was above average -- a mathematically impossible feat. It's the same phenomenon as the vast majority of drivers thinking they're above-average drivers. (Sorry, only half of us can actually be above average.)

Why You Need to Do Your Research

There are other takeaways from this study and others that can have a bearing on how you interpret professional advice and whether or not to act on it. For example:

A classic study found that when students were asked to spell words and estimate their accuracy, those with 100 percent confidence were accurate only about 80 percent of the time, and those with a confidence level around 80 percent were correct only about half of the time.

Confirmation bias is our natural tendency to start out with a premise or belief (for example, that a stock is a good buy or a love interest is a good match) and then focus mainly on evidence supporting that view. That tendency to see only what agrees with our previously held beliefs, and ignore data that conflicts with them, can lead us to overconfidence, in investing, relationships and more.

There are various studies suggesting that women tend to be better investors, in part because they tend to be less confident than men and therefore more risk-averse. Men also trade much more frequently, which can significantly reduce profits by boosting commission costs.

Business professors Terrance Odean and Brad Barber, well known for their studies of trading behavior, have cited overconfidence as a major factor in underperformance. In an article in the American Economic Review, Odean explained that: "The more overconfident an investor, the more he trades and the lower his expected utility. ... Overconfident investors ... have unrealistic beliefs about their expected trading profits ... at the worst, overconfident investors believe they have useful information when in fact they have no information."

Clearly, it can pay off if we question our assumptions and consider the possibility that in any given endeavor, we -- and our advisers -- may not be above average. Confidence isn't always a mistake: Some experts really do have the goods, some financial advisers really are acting in your best interests, and sometimes, you really do have the inside scoop. But keep an eye out for overconfidence in yourself and others: As much as you'll want to trust it, it has the potential to hurt you.

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Overconfidence Games: Why to Be Wary of Advisers Who Are '100% Sure'

Think again. Even student loan debt can chase you into retirement.

The Treasury Department has been withholding as much as 15% of Social Security benefits from a rapidly growing number of retirees who have fallen behind on federal student loans -- five times as many as in 2001. Even something as simple as credit card debt can hurt you in retirement, says John Ulzheimer, president of SmartCredit.com.

"When it comes to credit card debt, you absolutely have to get out of it before you hang up your company badge," Ulzheimer says. "It's very likely the most expensive debt you're carrying at 13 percent to 15 percent interest on average, and twice that in some cases. No retirement nest egg can guarantee that kind of growth."

Leaving the workforce might help you cut costs in some areas -- for example, your pricey commute to the office -- but you can never underestimate the cost of aging.

"Many studies show that some retirees even spend more in retirement than they did when they were working," says Susan Garland, editor of Kiplinger's Retirement Report.

"In the early years, you may be embarking on long-delayed travel and hobbies. And as the years go by, your health care costs are sure to rise. House-related maintenance costs, insurance and property taxes are sure to be on the upswing as well."

"More and more Americans say they plan to pay for retirement by working longer, but in reality, many retirees end up quitting sooner than planned," says Greg Burrows, senior vice president for retirement and investor services at The Principal.

One third of American workers said they plan on working past age 65 in a recent survey by the Employee Benefit Research Institute, but more than 70 percent of retirees said they actually quit before that milestone.

Then there's the job market to consider, which doesn't take kindly to workers who are past their prime. In 2011, the median length of unemployment for people 55 and older was 35 weeks, up from 10 weeks before the recession, according to the Government Accountability Office.

Medicare is an excellent resource for retirees needing health care support, but here's a wake up call: It doesn't cover all long-term care.

Medicare coverage excludes extended nursing home stays, custodial care, or an in-home nurse to help out if you're unable to dress, feed or bathe yourself.

"Medicare pays for limited nursing-home and home-health care for short periods to provide continuing care after a hospital stay," Garland says. "For example, skilled care in a facility is limited to 100 days. It may be wise to consider long-term care insurance to cover those costs."

Never underestimate the crippling power inflation has over your retirement savings.

"Too many people have the illusion that money is safe as long as the balance doesn't go down, but the reality is that inflation will eat into your purchasing power unless you learn how to properly manage and invest your wealth," writes David Ning of MoneyNing.com.

"Those who put all their money in a savings account may not experience the volatility that comes with different investments, but they are sure to be able to afford less and less as years go by, which is a real threat too."

Contrary to popular belief, investing savvy isn't something only the rich are born with.

But if you want to invest wisely, do yourself a favor and leave the stock picking and day trading to the professionals.

"Stick to the boring but effective strategy of saving early and often, watch investing fees, and picking an asset allocation plan where you can stay the course when the market inevitably takes a dive," says Ning.

And start as early as possible. According to personal finance expert Kimberly Palmer, someone who begins investing at age 25 will only have to save $4,830 annually to reach $1 million by age 65, accounting for an annual return of 7 percent after fees.

That figure triples to $15,240 if you wait until your 40s.

At some time (and for a lot of you, many times), life eventually will get in the way and you'll find yourself on the wrong side of your bank or, worse, a debt collector.

Stand your ground and watch them like a hawk. That means reading the fine print before signing up for a high-interest, high-fee credit card and taking a proactive approach to lower your interest rates on credit and mortgage loans. Sometimes, all it takes is a phone call and a little math work to figure out you could be getting a better deal elsewhere.

When in doubt, think about Kenny Golde, a 40-something producer we spoke with last year. He managed to negotiate $220,000 worth of debt down to $70,000 on his own.

It turns out one in four workers resorts to taking out 401(k) loans each year, to the tune of $70 billion, nationally.

And don't forget about the fees. Workers under age 59 1/2 who dip into retirement funds must generally pay back their loan quickly, between 30 to 90 days in most cases. Otherwise, you could wind up paying income taxes on whatever you've taken out, along with a 10 percent early withdrawal penalty. And you still have to pay back the loan with interest -- and with after-tax money, which then gets taxed again when you withdraw it in retirement.

We'll never tire of the Roth vs. Traditional 401(k) debate. With a Roth 401(k) or Roth IRA, all of your contributions are taxed immediately according to whatever tax bracket you fall into today. Traditional IRAs are tax-deferred until retirement.

The general consensus is that it's better to convert to or start a Roth now, since it's likely that you will wind up retiring in a higher tax bracket than you occupy now, in which case you'll pay significantly more in taxes later than you would today.

But investors who've already built a substantial IRA or 401(k) often can't stomach the thought of paying taxes on everything at once if they make the switch.

"Sometimes it just takes a lot of handholding because investors don't like to write that check," says Janet Briaud, chief investment officer of Briaud Financial Advisors. "There is sticker shock, but in the long-term, our clients really get it. They're really happy."

Ultimately, that money will be taxed one way or the other, either starting at age 70 1/2 when required minimum distributions take effect, or during the life expectancy of the beneficiaries, she argues. And if you leave a Roth IRA to your loved ones, you'll have the peace of mind of knowing they won't have to pay taxes on the money they withdraw.

To help ease the blow, speak with your advisor and try a partial conversion by moving just part of your savings to a Roth each year.

"Start by estimating your post-retirement expenses. Average it out across a year. From there, estimate what sort of investment returns you'll be able to generate -- yes, you'll need a crystal ball for this.

"From there, divide that rate (as a decimal) into one to find your multiplier. So, for example, if you think you can generate 4% real returns (i.e., 4% returns after accounts for inflation, so more like 7% nominal returns) then you'll need 25x your annual expenses (1 / 0.04 = 25). If you think you'll only be able to generate 3% real returns, then you'll need 33x your expenses. And so on."

The benefit of saving for your children's college education early (ideally via a 529 plan) is that you limit your saving burden by spreading it out over time.

But even if you come up short of tuition costs, don't immediately dip into you retirement savings to make up the difference.

"You can always fall back on financial aid. Grants, scholarships and student loans can help pay your child's way," writes Learnvest's Laura Shin. "When it comes to your retirement, however, there are no loans."

Of course, few people have the benefit of unlimited cash flow without putting in a little leg work first. But there are higher priorities in life than working overtime and depriving yourself of a few pleasures today just to save a buck or two.

"People spend most of their time planning their finances for old age, but not their fulfillment" along the way, says Ken Budd, executive editor of AARP The Magazine.

"We once profiled a man who decided that for the first year of retirement he would do whatever he wanted. So he went for long walks, he skimmed the newspaper online, he sat in Starbucks and read Grisham novels. But after that, he [felt so bored] he decided to become a chaplain."

Without a plan in place, you could leave your estate's future in the hands of squabbling family members or your state, which would appoint an administrator to handle everything.

"[A will] enables you to start thinking about issues like whether you have the right insurance coverage, life insurance, and ways of replacing your lost income," RocketLawyer founder Charley Moore says.

This is doubly important for gay spouses, as states that don't recognize gay marriages would pass over same-sex spouses in favor of next of kin.